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**Unformatted text preview: **Solutions Tutorial Week 10 Chapter 17 11. We begin with r E and the capital asset pricing model: r E = r f + E (r m r f ) = 0.10 + 1.5 (0.18 0.10) = 0.22 = 22.0% Similarly for debt: r D = r f + D (r m r f ) 0.12 = 0.10 + D (0.18 0.10) D = 0.25 Also, we know that: 17.0% 0.17 0.22) (0.5 0.12) (0.5 E D A r E D E r E D D r = = + = + + + = To solve for A , use the following: 0.875 1.5) (0.5 0.25) (0.5 E D E E D D E D A = + = + + + = 12. We know from Proposition I that the value of the firm will not change. Also, because the expected operating income is unaffected by changes in leverage, the firms overall cost of capital will not change. In other words, r A remains equal to 17% and A remains equal to 0.875. However, risk and, hence, the expected return for equity and for debt, will change. We know that r D is 11%, so that, for debt: r D = r f + D (r m r f ) 0.11 = 0.10 + D (0.18 0.10) D = 0.125= 0....

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